Don't Go Broke Buying Bankrupt Stocks

Sometimes, when stocks drop precipitously, they can easily over do it on the downside, as panic-selling ensues. These large declines can provide an attractive entry point for investors. The problem is that the biggest declines in stocks often occur the day that a company files for bankruptcy. Does that mean that bankrupt stocks can be a good buy? No, although some people don't realize that. Before buying that company that just filed Chapter 11, know the facts, and find out why any amount of money put in is bound to be lost. (To learn more details about a Chapter 11 filing, refer to An Overview of Corporate Bankruptcy.)

When a Company LiquidatesCompanies do not want to go bankrupt. Management will lose their jobs, and usually have equity at risk in the company. Companies declare or get forced into bankruptcy as a last resort, because they are having trouble paying their debt and need to gain protection from creditors. If the company liquidates or reorganizes, it needs to pay back everyone else in line before the common shareholders.

The hierarchy of claims goes like this: Bondholders including all classes (ie. subordinated, unsubordinated, secured, unsecured) have first claim to any assets or payments. After that the company may need to make payments for taxes, employees, trustees, etc. Then comes preferred equity holders, and, if there are any, the common equity holders get the leftovers. It's unlikely that shareholders receive anything.

When a Company RestructuresEven when the company will remain a going concern after emerging from chapter 11, the old shares are generally canceled with no payment to holders. New shares are issued, generally as a form of payment to debt holders.

An example of this was Delta Airlines. Delta filed Chapter 11 in 2005 and, following the filing, common shares traded over the counter on the pink sheets. Under its plan of reorganization, Delta was to issue new shares upon emergence from bankruptcy and cancel the old shares, with holders receiving no value. Delta even set up an online "Restructuring FAQs for Investors", where they specifically outlined how old shareholders will receive nothing. The website stated:

Under the proposed plan of reorganization, current holders of Delta common stock would receive no distribution, and the securities would be canceled upon the effective date of the plan. Delta has indicated for some time that the company expected its common stock would not have any value under any plan of reorganization the company might propose, which is not uncommon in Chapter 11 proceedings.

The company also explicitly pointed out: "Since the expected value of the Company will be less than creditors' claims, we will not be able to exchange 'old stock' for 'new stock'."

Despite this clear declaration that holders of old stock would receive nothing, shares exchanged hands at 13 cents just a week before the shares were set to be canceled. Thirteen cents doesn't seem like a lot of money, but for those who were buying 10,000 shares, the loss a week later was a very real $1,300.

Why Bankrupt Stocks Don't Trade at ZeroAs we've seen with Delta, the residual value of the shares is zero, so why doesn't every stock trade at zero after declaring bankruptcy? Stocks generally get close to zero on the day of the bankrupt, but can rise afterwards - sometimes even doubling or tripling. This affords some lucky individuals big gains. It is basically equivalent to a lottery ticket and generally has no basis whatsoever. So speculators, much like those who ride other penny stocks, make quick trades in the stocks trying to make big profits, but they also experience big losses. This type of strategy makes little sense with bankrupt stocks, as someone is buying something worth nothing, and hoping to sell it to someone else for more. It is an extreme example of the greater fool theory.

The other reason why a bankrupt stock won't trade at zero is because in rare cases some value may emerge for the common shareholders to claim. This will occur in a situation where the company is able to sell assets for higher than expected prices and can pay off everyone in line, and still have some left over. This, I remind you, is very rare. As stated above, the reason a company declares or gets forced into bankruptcy is because it cannot afford to pay its creditors. (Instead of investing in equity, some investors invest in distressed debt to make a profit; learn more in our article Distressed Debt An Avenue To Profit In Corporate Bankruptcy.)

What About Price-to-Book Value?A commonly used metric to judge the value of a company is its book value. When looking at book value, the stock of a bankrupt company may look compelling, as it will trade for a small fraction of book value. This, however, cannot be used to determine that there is value in the stock. First, book value contains many things that are of little or no value during bankruptcy, such as goodwill. On top of this, any assets that get sold off in a bankruptcy proceeding will likely receive distressed prices, as buyers will not pay up for assets in liquidation.

The Bottom LineDon't buy bankrupt stocks. Unless you have some great research on the stock and the bankruptcy proceedings, and have truly figured out that the company can generate enough cash to pay all claims and then some, there is no reason to do it. While buying a stock that was trading at $20 and is now at 20 cents may seem compelling, the vast majority of the time that 20 cents is worth nothing. So why throw away money and look like a fool? If you're looking for something else to buy, I have a great price on a bridge in Brooklyn. For related reading, check out Taking Advantage of Corporate Decline.